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New Zealand banks could cope when faced with an extreme scenario in which house price plunged by 47% and unemployment spiked to 9.3%, although it would reduce the level of capital they held as a buffer.

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This was according to the Reserve Bank of New Zealand after its annual stress testing of the sector, which covered big banks ANZ, ASB, BNZ, Westpac, and Kiwibank, as well as four smaller banks, to better understand the implications of risks to bank balance sheets and the overall financial stability.

The stress test found that in a scenario where property values fell 47% from the peak in November, share prices were down 38%, unemployment rose sharply, the OCR peaked at 5.5%, two-year fixed mortgage rates hit 8.4%, with a one-in-25-year cyber risk event, banks’ common equity tier 1 ratio would decline 3.3 percentage points to 8.9%, which was still well above the 4.5% minimum, NZ Herald reported.

“Although banks’ capital buffers would be reduced in such a scenario, they would still remain well above our regulatory minimum, thanks in part to the build-up of capital since the 2008 Global Financial Crisis, enabling them to continue to support their customers and the economy,” said Christian Hawkesby, RBNZ deputy governor.

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The RBNZ report also noted, however, that households and businesses would find the environment very challenging, with many bank customers unable to repay their loans and experiencing large falls in wealth.

The scenario could see banks potentially incur $20.8 billion in impairment expenses over four years. That compared to $1.7bn in real impairment costs from the COVID-19 pandemic over the last four years.

Banks would also likely make a loss after two years, while the cyber event would lead to costs of $1.3bn.

It was found that people default on their mortgages primarily due to unemployment.

“However, mortgage rates became an important driver of defaults as they increased above 6% to 7%, consistent with test rates that large banks have used since 2019 for their affordability assessments of mortgage applications,” Hawkesby said.

RBNZ said it was its first stress test since 2014 involving high interest rates – and that banks had found it difficult to model the impact of higher interest rates because they lack historical data.

“This highlighted some limitations for the stress test modelling of new economic risk factors,” Hawkesby said. “A number of banks indicated they are investing in their modelling capability and that this stress test proved a useful exercise.”

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It was also the first stress test undertaken under the RBNZ’s new capital framework, which began in July and required banks to progressively hold more capital.

According to the central bank, the combination of the stress event and rising capital requirements could make it difficult for banks to meet the new capital requirements when fully implemented in 2028, New Zealand Herald reported.